Contaminated Properties Becoming New Investment Niche in Tight California Real Estate Markets
By Daniel Johnson

A growing number of California developers are realizing that getting their hands a little dirty can really pay off, especially in tight real estate markets (i.e., San Diego) that currently face land shortages and “cap” rates in the five or six range in low-risk niches such as apartments.

Of the estimated 500,000 contaminated sites that sit abandoned across the U.S., at least 100,000 sites are located in California with estimates of fair market value in the hundreds of billions. Although the risk and hold times may not appeal to every investor, the rate of return can be substantial. Several recent changes have made the risk more manageable than it has ever been.

The acquisition of contaminated properties has become an increasingly important investment niche for savvy developers looking for better rates of return. Buyers and lenders alike are looking more closely at properties with environmental issues for two key reasons: 1) regulatory reforms, such as clearer guidelines regarding due diligence, have been implemented to reduce liability and increase protection for property owners; and 2) affordable insurance to adequately address environmental concerns increasingly has become available.

Regulatory Reforms & Due Diligence

State and federal regulatory reforms regarding due diligence have been tailored toward helping developers understand and minimize liabilities, while providing for productive use quickly and inexpensively. The driving force behind due diligence has historically been the Comprehensive Environmental Response, Compensation and Liability Act / Superfund Amendments and Reauthorization Act (CERCLA/SARA). Enacted in 1986, SARA serves as an addendum to the original Superfund law of 1980. To date, CERCLA, or “Superfund,” has achieved the following: 1) established prohibitions and requirements concerning closed and abandoned hazardous waste sites; 2) provided for joint, strict, and retroactive liability of persons responsible for releases of hazardous waste at these sites; and 3) established a trust fund to provide for cleanup when no responsible party could be identified.
Superfund has always had an “out” by allowing the assertion of the “innocent landowner defense” to liability, requiring that “all appropriate inquiry into the previous ownership and uses of the property be consistent with good commercial or customary practice.” Until recently, the criteria to qualify as an innocent landowner were uncertain at best. Fortunately, recent amendments to Superfund clarify what constitutes "all appropriate inquiry." The Small Business Liability Relief and Brownfields Revitalization Act (“the Amendments”) became effective in 2002. The Amendments embrace the American Society for Testing and Materials (ASTM) Standard Practice for Environmental Site Assessment (E1527-97). The Amendments also require the Environmental Protection Agency (EPA) to adopt regulations within two years that establish standards for "appropriate inquiry." The EPA is currently working with stakeholders on this process.

Other liability clarifications, such as for “contiguous property owners” and “bona fide purchasers,” also are included in the Amendments, although their practical effects may be limited. Interestingly, the Amendments specifically provide for the purchase of a contaminated property, while limiting liability, if certain conditions are met.

For developers looking to acquire a contaminated property, performing due diligence means conducting a very thorough -- and required -- Phase I site assessment, which should meet or exceed the ASTM guidelines. A typical Phase I is conducted by a qualified environmental consultant and includes site reconnaissance, interviews with on-site and off-site sources, regulatory reviews, and thorough analysis of the site and site vicinity history.
The updated ASTM standards address some long-standing problems with Phase I assessments. Many lenders requesting Phase I assessments under the previous standards assumed that the property was going to be investigated for all forms of contamination, not knowing that ASTM standards excluded such environmental risks as asbestos, radon, lead-based paint, lead in drinking water, and wetlands. To alleviate this confusion, ASTM 2000 addresses “business environmental risk,” a term that adds and clarifies “non-ASTM scope” items to the list of environmental risks that the ASTM scope initially addressed. These expanded “non-scope” risks include regulatory compliance, ecological resources, endangered species, indoor air quality (i.e., mold), cultural and historic resources, industrial hygiene, health and safety, and high-voltage power lines.

Environmental Insurance

Environmental insurance can cap liability and/or remove liability reserves from the balance sheet, thereby limiting risk to the buyer/developer and minimizing contingent obligations of the seller/property owner. Further, it provides a method to quantify economic risks associated with environmentally impaired properties, while enhancing access to debt capital.

Consider a recent $10 million real estate transaction involving a contaminated property, with initial estimates of contingent cleanup costs and liability in excess of $100,000. The site’s contamination stemmed from on-site tenant operations, as well as the migration of contaminants from an offsite leaking underground storage tank (LUST). A major oil company had been involved in mitigating the plume from the LUST. The tenant arguably was obligated as the operator under the lease for pollution problems caused by their operations, but no contractual agreement had existed to cover the pollution from the oil company. The buyer of the property, in need of assurance that both the oil company and the tenant would fulfill remediation obligations, obtained a pollution legal liability (PLL) policy. This coverage protected the buyer from first- and third-party claims by covering preexisting known conditions as well as unknown conditions. Without this insurance, the deal could not have proceeded.
Another recent real estate transaction involved the buyer of a commercial facility with automotive operations. The buyer’s lender was concerned about a few historical environmental issues surrounding the site: the historic presence of underground storage tanks; the site’s former usage as a gas station; and its close proximity to a landfill. To satisfy the lender’s concerns, the buyer worked with the lender to obtain “secured creditor” insurance coverage to protect the lender from potential liability. As a result, the buyer was able to secure a loan to purchase the property and close the deal.

Determining the best environmental insurance policy first requires an understanding of the risk management considerations for a particular contaminated property. Issues impacting parties to contaminated property transactions can include known, unknown, and under-funded environmental liabilities; adverse development of known environmental liabilities; and pending litigation. The four major types of environmental insurance coverage are outlined below:

Cost Cap/Stop Loss. This type of coverage works for anyone involved in remediating contaminating properties. It minimizes uncertainty by paying for defined cleanup costs that exceed the anticipated cost of cleanup. It also provides a buffer above the expected cleanup costs. A remedial action plan is usually a prerequisite to obtaining this type of coverage.

Environmental Impairment Liability (EIL). EIL coverage is site specific and covers first and third parties. It covers both preexisting and new claims for known conditions. Policy terms can extend up to 10 years, with coverage ranging from $15 million to $100 million.

Finite Program. The entire expected cleanup costs may be included in a finite insurance program. It usually is recommended for larger projects ($4.5 to $5 million and up), although small project are sometimes considered. A finite program requires a remediation action plan and accurate estimation of annual cleanup costs.
Lenders Coverage. Two major concerns of lenders regarding environmentally impaired properties are the potential environmental liability and compromise of their collateral. Secured creditor insurance is designed to protect lenders from loss of collateral value, the inability of the borrower to repay the loan, and liability of environmental conditions on foreclosed properties. Lenders coverage might make lenders more willing to provide capital on contaminated properties.

Prime Investment Sites

Sites with leaking underground storage tanks (LUSTs) are excellent redevelopment candidates. There are more than 30,000 LUST sites in California, with thousands of sites in San Diego. Interestingly, LUST remediation often can be reimbursed through a state cleanup fund, or sometimes can be covered by insurance. Risk-based corrective action (RBCA) may facilitate the redevelopment and cleanup of these sites.

"Contiguous property,” such as contaminated groundwater sites, also can be prime investment opportunities. Taking ownership of property located over contaminated groundwater from an adjacent site is not necessarily problematic for developers if the subject site did not cause or contribute to the contamination. While some lenders may be wary of these sites, obtaining a “comfort” letter from an environmental agency may rectify the situation. In addition, almost all urban areas encompass numerous brownfield properties in need of remediation. With increasing demand for “infill” development opportunities, soaring housing prices, and pressure for “smart growth,” urban cores are prime locations for the acquisition of redevelopment and brownfields properties.
For example, Environmental Business Solutions was retained by Centre City Development Corporation (CCDC) to perform historical and regulatory research of the 35-block portion of downtown San Diego’s East Village Redevelopment area, which encompasses the 7-block footprint of the new San Diego Padres ballpark. Contamination stemming from a history of commercial and industrial uses dating back to the 1800s was discovered through Phase I and Phase II site investigations. The remediation project, which has garnered several awards, is part of a $1 billion redevelopment effort to revitalize East Village, making it the largest project of its kind ever conducted in California.

Getting the Deal Done

Once due diligence efforts and possible insurance coverages have been examined, buyers/developers still must determine how to incorporate them into the overall acquisition process. Access to specialized assistance and counsel is critical. Firms that have experience in executing these types of projects, not just in conducting due diligence, should be interviewed. For serious investors in this market, consideration should be given to retaining an independent consultant to review or manage the due diligence or remediation process. Doing so can be helpful because “intellectual capital” required for more complex projects is substantial, and most small to medium developers do not have these internal resources.

Strategies for executing the transaction in an orderly and efficient manner are outlined below:

• Consult with financing sources to understand their needs upfront.
• Consider environmental insurance.
• Obtain seller disclosures and be sure to collect all available information.
• Incorporate risks and known areas of contamination into project design to help minimize remediation costs.
• Evaluate legal protections and include all available possibilities.
• Determine Agency participation in case agency oversight is required.
• Select a cleanup program and define in it the scope of work.
• Contract for all remediation and demolition work.
• Allocate cleanup costs and establish a workable cleanup standard.
• Evaluate disclosure obligations to determine what to say to prospective tenants or buyers, once the property is acquired or redeveloped.

Needless to say, real estate investments always carry their share of risks. For developers considering contaminated property acquisitions, the desired rate of return must be balanced against such factors as time constraints, limitations of land use, scope of necessary due diligence, liability risks, and insurance costs. Keep in mind that the fundamentals of any real estate transaction still apply. Some properties are truly “upside down” and, even if available at zero cost, are not worth it. However, for the savvy investor, “dirty dealing” can be an interesting and rewarding experience.

Daniel E. Johnson is the founder of Environmental Business Solutions (EBS), an operating division of SCS Engineers. The company provides Phase I site assessments, environmental audits, Phase II assessments, remediation services, environmental screening, underground storage tank solutions, litigation support, risk assessments, and consulting services for brownfields redevelopment, regulatory compliance, storm water compliance, and ISO 14001 qualification. More information about the company can be found on the web at www.ebsenvironmental.com or www.scsengineers.com.